'Read China's Lips': Commentary by Stephen Roach
"Read China's Lips"
By Stephen Roach
Published July 27, 2011, by Project Syndicate.
Read this article in its original context on the Project Syndicate website.
The Chinese have long admired America's economic dynamism. But they have lost confidence in America's government and its dysfunctional economic stewardship. That message came through loud and clear in my recent travels to Beijing, Shanghai, Chongqing, and Hong Kong.
Coming so shortly on the heels of the subprime crisis, the debate over the debt ceiling and the budget deficit is the last straw. Senior Chinese officials are appalled at how the United States allows politics to trump financial stability. One high-ranking policymaker noted in mid-July, "This is truly shocking… We understand politics, but your government's continued recklessness is astonishing."
China is no innocent bystander in America's race to the abyss. In the aftermath of the Asian financial crisis of the late 1990s, China amassed some $3.2 trillion in foreign-exchange reserves in order to insulate its system from external shocks. Fully two-thirds of that total—around $2 trillion—is invested in dollar-based assets, largely U.S. Treasuries and agency securities (i.e., Fannie Mae and Freddie Mac). As a result, China surpassed Japan in late 2008 as the largest foreign holder of U.S. financial assets.
Not only did China feel secure in placing such a large bet on the once relatively riskless components of the world's reserve currency, but its exchange-rate policy left it little choice. In order to maintain a tight relationship between the renminbi and the dollar, China had to recycle a disproportionate share of its foreign-exchange reserves into dollar-based assets.
Those days are over. China recognizes that it no longer makes sense to stay with its current growth strategy—one that relies heavily on a combination of exports and a massive buffer of dollar-denominated foreign-exchange reserves. Three key developments led the Chinese leadership to this conclusion:
First, the crisis and Great Recession of 2008–2009 were a wake-up call. While Chinese export industries remain highly competitive, there are understandable doubts about the post-crisis state of foreign demand for Chinese products. From the U.S. to Europe to Japan—crisis-battered developed economies that collectively account for more than 40% of Chinese exports—end-market demand is likely to grow at a slower pace in the years ahead than it did during China's export boom of the past 30 years. Long the most powerful driver of Chinese growth, there is now considerable downside to an export-led impetus.
Second, the costs of the insurance premium—the outsize, largely dollar-denominated reservoir of China's foreign-exchange reserves—have been magnified by political risk. With U.S. government debt repayment now in play, the very concept of dollar-based riskless assets is in doubt.
In recent years, Chinese Premier Wen Jiabao and President Hu Jintao have repeatedly expressed concerns about U.S. fiscal policy and the safe-haven status of Treasuries. Like most Americans, China's leaders believe that the U.S. will ultimately dodge the bullet of an outright default. But that's not the point. There is now great skepticism as to the substance of any "fix"—especially one that relies on smoke and mirrors to postpone meaningful fiscal adjustment.
All of this spells lasting damage to the credibility of Washington's commitment to the "full faith and credit" of the U.S. government. And that raises serious questions about the wisdom of China's massive investments in dollar-denominated assets.
Finally, China's leadership is mindful of the risks implied by its own macroeconomic imbalances—and of the role that its export-led growth and dollar-based foreign-exchange accumulation plays in perpetuating those imbalances. Moreover, the Chinese understand the political pressure that a growth-starved developed world is putting on its tight management of the renminbi's exchange rate relative to the dollar—pressure that is strikingly reminiscent of a similar campaign directed at Japan in the mid-1980s.
However, unlike Japan, China will not accede to calls for a sharp one-off revaluation of the renminbi. At the same time, it recognizes the need to address these geopolitical tensions. But China will do so by providing stimulus to internal demand, thereby weaning itself from relying on dollar-based assets.
With these considerations in mind, China has adopted a very transparent response. Its new 12th Five-Year Plan says it all—a pro-consumption shift in China's economic structure that addresses head-on China's unsustainable imbalances. By focusing on job creation in services, massive urbanization, and the broadening of its social safety net, there will be a big boost to labor income and consumer purchasing power. As a result, the consumption share of the Chinese economy could increase by at least five percentage points of GDP by 2015.
A consumer-led rebalancing addresses many of the tensions noted above. It moves economic growth away from a dangerous overreliance on external demand, while shifting support to untapped internal demand. In addition, it takes the heat off an undervalued currency as a prop to export growth, giving China considerable leeway to step up the pace of currency reforms.
But, by raising the consumption share of its GDP, China will also absorb much of its surplus saving. That could bring its current account into balance—or even into slight deficit—by 2015. That will sharply reduce the pace of foreign-exchange accumulation and cut into China's open-ended demand for dollar-denominated assets.
So China, the largest foreign buyer of U.S. government paper, will soon say, "enough." Yet another vacuous budget deal, in conjunction with weaker-than-expected growth for the U.S. economy for years to come, spells a protracted period of outsize government deficits. That raises the biggest question of all: lacking in Chinese demand for Treasuries, how will a savings-strapped U.S. economy fund itself without suffering a sharp decline in the dollar and/or a major increase in real long-term interest rates?
The cavalier response heard from Washington insiders is that the Chinese wouldn't dare spark such an endgame. After all, where else would they place their asset bets? Why would they risk losses in their massive portfolio of dollar-based assets?
China's answers to those questions are clear: it is no longer willing to risk financial and economic stability on the basis of Washington's hollow promises and tarnished economic stewardship. The Chinese are finally saying no. Read their lips.
Stephen S. Roach, a member of the faculty at Yale University, is non-executive chairman of Morgan Stanley Asia and the author of The Next Asia.